Last Gasp for Stock Options?

The once-popular form of pay, which for decades enriched senior executives and sometimes turned secretaries into millionaires, is almost disappearing as companies gravitate toward restricted stock awards.

The trend has accelerated in the past couple of years, in response to shareholder demands, tax-law changes and the financial crisis, which left executives and employees at many companies holding worthless options.

At their peak in 1999, stock options accounted for about 78% of the average executive’s long-term incentive packages. Last year, they represented just 31%, and are expected to shrink to 25% in the next two years, based on grant values so far this year, according to an analysis of the 200 largest U.S. public companies by compensation consulting firm James F. Reda & Associates.

“Options kind of got squeezed out,” says James Reda, the consulting firm’s managing director. Companies are rapidly replacing those grants with restricted stock, which offers a more “certain” return to employees, he says.

Stock options give employees the right to buy a company’s stock at a specified “strike price” at a predetermined date in the future, but they are worthless if the stock doesn’t reach that price. Restricted shares, on the other hand, give an employee the full value of a company’s stock, at a future date, or when a performance goal is reached.

Stock options, however, can be a much more powerful wealth generator. If a company’s stock rises by about a third, an options grant can end up being worth double a restricted-stock grant of the same size. Employees also have more control over the tax consequences when exercising options.

Even so, executives acknowledge that restricted stock is a simpler form of compensation, subject to fewer accounting and tax complexities. They say tax policies toward stock options can vary between countries, cities and states, but are more uniform for restricted stock.

Companies also have grown more accustomed to accounting for trade-offs between options and restricted stock, since accounting-rule changes that took effect in 2006 forced companies to record options as expenses. Before those changes companies didn’t have to count those costs against their income.

The Obama administration’s proposal to cut the corporate-tax rate to 28% by ending some deductions also could threaten a long-standing tax benefit that made stock options attractive. Ahead of its initial public offering last year, Facebook Inc. estimated that its tax deduction for stock options could be as much as $17 billion if all of its U.S. employees cashed out their holdings.

Corporate deductions for stock options total as much as $60 billion a year, according to Sen. Carl Levin, a Michigan Democrat who has proposed ending that benefit.

Options on stock that is trading below the strike price are called “out of the money,” because they don’t have any cash value. And that can hurt employee morale, says Duncan Robertson, chief financial officer of online restaurant-reservations service OpenTable Inc. “If they’re so heavily out of the money, stock options almost work in reverse.”

That may be part of the reason options have shown a similar pattern of decline among rank-and-file employees. From 2002 to 2010, the percentage of U.S. workers holding stock options declined by more than a third to just 8.7%, according to an analysis of data from the University of Chicago’s National Opinion Research Center by the National Center for Employee Ownership, a nonprofit research group.

Even in Silicon Valley, where stock options remain the currency of cash-poor startups, companies are pulling back on options grants as soon as they go public.

Take San Francisco-based real-estate website operator Trulia, which went public last year. Last week the company closed the acquisition of a real estate software maker for $355 million. But, rather than issue options to motivate the employees who will oversee the software maker’s integration, Trulia gave out restricted stock units that vest when its share price roughly doubles.

Because restricted shares are worth more to start, Trulia was able to give out fewer of them than options, avoiding shareholder complaints about dilution of their holdings.

The original idea behind stock options was that they would motivate management to boost a company’s stock price. But Institutional Shareholder Services Inc., which advises big investors on corporate governance, says it doesn’t consider stock options to be a performance-based form of pay. A hot market could drive a company’s shares above an option’s strike price even if the company’s executives were underperforming its peers.

Corporate directors are often skeptical of that argument, because many of them made their fortunes with stock options, says Mr. Reda, the consultant.

In any case, it would be premature to pronounce stock options dead. Option grants could pick up again if executives demanded them, Mr. Reda added.

At Internet radio company Pandora Media Inc., the company’s new CFO, Mike Herring, asked the board this year to pay all of his incentive compensation in stock options. He says that will push him to stay ahead of competition.

“In this rapid-growth, world-is-on-fire kind of market, I shouldn’t get any credit for protecting existing value,” he says. “This is all about how do I create incremental growth from here, and I should only be compensated for incremental shareholder value if I do that well.”

Nevertheless, since going public two years ago, Pandora has shifted to restricted stock for general employees, who don’t have the same kind of control over the company’s strategy as its executives. In its proxy statement in April, the company said the move was designed to encourage employee “retention in a volatile market.”

Restricted stock units “are simpler, create less risk for employees and less dilution,” Mr. Herring said. “No matter what happens, they need to be able to count on that piece of their compensation.”

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